31 Small states and big banks – the case of Iceland Hilmar Þór Hilmarsson1 Abstract The Icelandic economy was hit hard by the global economic and financial crisis that started in the fall of 2008. During this crisis the three largest banks all collapsed and many other smaller banks and companies went bankrupt in the aftermath of the crisis with severe consequences for the economy and the people. Prior to the crisis, Iceland, a high income economy, had experienced strong growth rates and unprecedented expansion in overseas investment and activities, especially in the financial sector. This article focuses on action by top government officials during this expansion as well as during and after the collapse of the Icelandic banks. The findings of the study are that the government showed negligence and made mistakes by not taking credible action to manage risks following a rapid cross border expansion of the Icelandic banking system. This had severe consequences and resulted in the collapse of the Icelandic economy in October 2008. The discussion can have a wider relevance than that for Iceland only. This is especially true for small countries with a large banking sector, using their own currency, and with limited fiscal space to support their banks during a crisis. Keywords: Economic and financial crisis, economic policy, international expansion of firms, risk management. JEL Classification: F21, G32, H12 1. Introduction The Icelandic economy was hit hard by the global economic and financial crisis that start- ed in the fall of 2008. During this crisis the three largest banks (Glitnir, Kaupthing, and Landsbanki)2 all collapsed and many other smaller banks and companies went bankrupt in the aftermath of the crisis with severe consequences for the economy and the people. Prior to the crisis, Iceland, a high income OECD economy, had experienced strong growth rates and unprecedented expansion in overseas investment and activities, especially in the financial sector. This article will focus on action by top government officials during this expansion as well as during and after the collapse of the Icelandic banks. Did the government of Iceland fuel the international expansion of the Icelandic banking sector that eventually resulted in collapse? How did it react to the banks’ expansion and what action did it take, or not take, to protect the economy from collapse? How did it respond to international concerns about the banks’ overseas expansion? Can its behavior be classified as negligence? 1 Hilmar Þór Hilmarsson, Ph.D., is a Professor at the School of Business and Science, University of Akureyri, Borgir v/Norðurslóð, 600 Akureyri, Iceland, e-mail: [email protected] 2 The three banks accounted for about 85% of Iceland’s financial system. 32 Baltic Journal of Economics 13(1) (2013) 31-48 The government officials focused on are the President of Iceland, who has traditionally been a symbolic and ceremonial figure in the government, as well as the role of key cabinet ministers including the Prime Minister, the Minister of Finance, and the Minister of Business Affairs. After this brief introduction the article will be organized as follows: (i) the expansion of the banking sector in Iceland, (ii) what did experts say about the health of the Icelandic banks before and after the collapse in October 2008 (were the banks solvent after all?), (iii) how did the government react to concerns and criticism about the banking system prior to the crisis, (iv) the Special Investigation Commission and its report to the parliament, (v) the President of Iceland and the expansion of the Icelandic banks, (vi) the role of the Central Bank of Iceland (CIB) and the Icelandic Financial Supervisor (FME), (vii) some thoughts on how the crisis could have been prevented, and finally (viii) conclusions. This article is based on a review of theoretical literature, reports, public speeches, local and international media news, and secondary data. This is a case study on Iceland. Some of the lessons, however, can have a wider relevance than for Iceland only. This is especially true for small countries with a large banking sector, using their own currency, and with limited fiscal space to support their banks during a crisis. 2. The expansion of the banking sector in Iceland Prior to the global economic and financial crisis that started in October 2008 the Icelandic banks had grown extraordinarily. According to the IMF the consolidated assets of the three main Icelandic banks increased from 100 percent of GDP in 2004 to 923 percent at end 2007, reflecting expansion overseas. By end-2007, almost 50 percent of the three banks’ assets were held abroad (IMF, 2008, p. 11) Access to global debt finance markets was a key driving force behind this growth. The big three banks also enjoyed high credit ratings inherited from Iceland‘s sovereign debt rating at the time. According to the Special Investigation Commission (SIC)3 the three banks issued around 14 billion EUR in foreign debt securities markets during 2005, a little over the GDP of Iceland that year. Most of the funding matured in only 3 to 5 years. Refinancing risk was thus imminent (SIC, 2010a). In early 2006, during the so called mini crisis, international debt funding dried up temporar- ily. Once a liquidity crisis started in 2007, foreign deposits and short-term securitized funding became the main source of funding for the three banks. This short-term funding was sensitive to market conditions and thus risky (SIC, 2010a). According to the SIC other countries with relatively large financial systems managed to avoid disastrous banking outcomes, since, unlike Iceland, those nations have long experience and proven ability to supervise large, international banks. Their accumulated reputation for careful prudential supervision therefore offsets their inability to provide fully reliable lender 3 The Special Investigation Commission (SIC) delivered its report to the Althingi (the Icelandic parliament) on April 12, 2010. The SIC was established by Act No. 142/2008 by the Althingi in December 2008, to investigate and analyze the processes leading to the collapse of the three main banks in Iceland. Members of the Commission were Supreme Court Judge Mr. Páll Hreinsson, the Parliamentary Ombudsman of Iceland Mr. Tryggvi Gunnarsson, and Mrs. Sigríður Benediktsdóttir Ph.D., lecturer and associate chair at Yale University, USA. Small states and big banks – the case of Iceland 33 of last resort protection, at least to some extent. But in Iceland the Financial Supervisory Authority (FME)4 was in general understaffed and lacked experience, the Central Bank of Iceland’s (CBI) foreign currency reserve was low, and the deposit insurance fund was under- funded (SIC, 2010a). How could this happen in a high income developed country like Iceland? How could Iceland move from privatization of state owned banks to an exploding banking sector and then to collapse? 3. What did the experts say about the health of the Icelandic banks before and after the collapse? A number of experts, local and foreign, commented on the viability of the Icelandic banking system as well as on the soundness of the government’s macroeconomic policies both prior to the banks’ collapse (including after the so called mini-crisis in 2006) as well as after the col- lapse in October 2008. It is especially interesting to recall remarks made prior to the collapse as they may have influenced government action or inaction. It is also interesting to review some comments made after the collapse to see what lessons may have been learned from this catastrophic event. 3.1 Before the collapse of the banks in October 2008 Danske Bank issued a critical report in 2006 highlighting some of the macroeconomic im- balances in Iceland. “Based on the macro data alone, we think the economy is heading for a recession in 2006-7. GDP could probably dip 5-10% in the next 2 years, and inflation is likely to spike above 10% as the ISK depreciates markedly” and “we see a substantial risk of a financial crisis developing as an integral part of an Icelandic recession in 2006-7.” (Danske Bank, 2006). Iceland is a former colony of Denmark and large investments had recently been made there by Icelandic companies so that any negative comments from Copenhagen were likely to be received with some suspicion in Reykjavík. Talking about a possible financial crisis during a period that many people experienced as a boom was not likely to be taken too seriously in Iceland. Nevertheless Icelandic business interests and cabinet ministers re- sponded with assistance from individuals in academia. An international PR campaign was launched to present a favorable view of the Icelandic banks and point to a strong government that balanced its fiscal budget and carried only small debts on its books. The Iceland Cham- ber of Commerce commissioned well known and respected Icelandic economists who joined forces with distinguished and internationally known foreign colleagues who together painted a favorable picture of Iceland´s banking system and its economy. In 2006 Herbertsson and Mishkin issued a report entitled: “Financial stability in Iceland” (Herbertsson and Mishkin, 2006) and in 2007 Baldursson and Porters issued a report entitled: “The internationalization of Iceland‘s financial sector” (Baldursson and Porters, 2007). The title of the Herbertsson and Mishkin report is especially ironic given what happened in 2008 and in fact Mishkin was accused in the famous movie “Inside Job”5 of having changed the title of the paper on 4 The Financial Supervisory Authority in Iceland is a regulatory organisation charged with the task of supervising financial enterprises, referred to as regulated entities (see furtherhttp://en.fme.is/about-the-fsa/ ). 5 In the movie “Inside job” Mishkin is said to have received US$124.000 for his contribution to the report http://www.